Identifying a winner

Mutual Funds selectionMutual funds are one of those select investment instruments that have the potential of considerable high returns over a period of time, with marginal risk factor associated. Another lucrative factor to include MFs to your investment bucket is the snowball effect (power of compounding) linked with Systematic Investment Plan (SIP) in MFs. We will discuss about SIPs in later posts.

Selecting a MF is a very crucial decision as it has to be inclined with your goals and risk appetite. Let us look at some of the elementary parameters we should check before making a decision.



1. Returns over a period of time:

First and foremost is the performance of the fund in the last couple of months/years, which means trend of historic returns. As this could be used as a projection of it’s returns in future as well. When looking at historic returns the most decent period to be looked at could be 6 months, 1 year, 3 year and 5 years.

Not to forget these figures are just an indication of fund’s performance; decision could not be based completely on this criterion; since the start and end date for calculation of these returns are not standardized and differ from fund to fund which causes the returns to vary as well.


2. Portfolio:

Next comes the portfolio of the target mutual fund. When you are investing in a mutual fund it is not the mutual fund that you intend to invest but you invest in the underlying instruments contained in its portfolio (where that fund invests). So while selecting a mutual fund always start from self analysis (how much risk you can bear for desired returns) then fundamental analysis (identify growth potential) of equity market at large to decide on sectors and stocks you would be more interested in.


3. Expense ratio:

Generally ignored but expense ratio forms one of the important factor while taking the decision. Expense ratio is what fund houses charge their investors for their operating expenses (i.e. what it costs these fund houses to operate a mutual fund). At the time of investing a fixed percentage is taken away from the money invested as expense ratio and only remaining part is invested to get units for your mutual fund.

For example if 1% is the expense ratio then for every Rs. 100 you invest only Rs. 99 are invested to buy units of that fund and Re. 1 is deducted against fund house expenses.


4. Risk return trade-off:

Investing in financial instruments is always accompanied by risk factor. But it is very crucial to calculate risk return trade-off. As investing in a fund with considerable risk but less returns is never a prudent decision.

Sharpe ratio helps to decide this trade-off. It is the measure of risk adjusted return i.e. it represents reward per unit of risk taken by the fund. So higher the sharpe ratio better it becomes to invest.


5. Ratio analysis:

Alongwith the sharpe ratio one can always look for alpha and beta of the fund. Alpha gives the excess return of the fund relative to the benchmark. A positive alpha means that the fund has outperformed the benchmark.

Beta coefficient is yet another measure that gives the sensitivity of the fund in correspondence with market movements. A beta of 1 indicates that the fund will move in accordance with markets and a beta of 1.10 would mean that there would be 10% more fluctuation in the fund’s NAV both during upside and downside of markets. So higher beta would mean high risk.


6. Asset Under Management (AUM):

Asset size of the fund does matter. As in a fund with considerable less asset size one could never be sure who those investors are. Those investors could be a large group of retail investors like us or could be just a few big investors in which case exit of any one of them could affect the fund adversely.

The asset size for an equity fund of at least a hundred crore and for debt fund a thousand crore is generally assumed to be a safe AUM.


7. Consistent ranking:

Last but not the least fund’s consistent ranking by rating agencies (crisil for instance) also play a major role. These ratings are based on the historic performance by funds over different time frames as compared to their peers. Even though these ratings are just a backward approach but they help to filter out the stable funds.

Investment is never a one time process. It demands your periodic attention to deliver the best. Once you are done with investing don’t forget to regularly monitor them and reshuffle them when situation demands.

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